Building Liquidity Awareness | Market Measures

It's best to learn the lesson of market liquidity the easy way, however, with most traders, that simply isn't the case.

I first learned about liquidity as a junior trader that was tasked with hedging some our firm's options positions at the end of the day. This was before we had instituted basket trading, so we often just went down the list by symbol and either bought or sold stock according to the delta of our option position.

In one particular case, I recall entering an order to buy 1,000 shares when the stock suddenly took off like it had just blasted off from Cape Canaveral.

Within a couple minutes, the stock was up $5 and then quickly up $10. While prematurely celebrating my day trading number (I had gotten filled on some stock before it popped), the senior trader next to me quickly ran some diagnostics on what had just occurred.

That's when he leaned over and quietly said, "Do you realize you just entered an order to buy 100,000 shares?” Given the name was trading above $70 and I was supposed to be buying roughly 1,000 shares, I shrank back into my seat about as far as the chair would allow. A trade that size represented a decent sized chunk of the entire daily volume.

Within 10 minutes, the stock had tailed back down from up $10 to up only about $3 - which meant we still had a nice profit on the 3,000+ shares I had bought a few dollars lower.

Obviously, the risk was that I'd have bought the entire 100,000 shares I entered before the stock dropped off a cliff - potentially a very expensive lesson.

The options market is no different than the stock market in the sense that liquidity plays a key role in the trading dynamics of the product.

There is a big difference between buying on the bid and buying on the ask, which is namely "the spread." When a seller is crossing the market and hitting the bid, this represents an ideal opportunity to add to long premium. The same can be said for when buyers are paying the ask and you are looking to sell.

The situation Tom and Tony highlight through this example is that large market moves (especially big down moves) can have an unbelievable impact on liquidity. When markets are crashing, market participants are scrambling to reevaluate their stance on valuation - whether it be stocks, options, or anything else.

In these cases, confidence drops and most market participants scale back in size. The financial crisis from 2007-2009 illustrated this situation perfectly as markets broke down across the board and stocks made jagged moves in every direction.

During this period, I had the good fortune to manage large derivatives portfolios that were both long premium (2007) and short premium (2008) which gave me a fairly comprehensive look at how options markets behave during a crisis.

When negative events like the Bear Stearns and Lehman Brothers bankruptcies hit the market, option liquidity on the offer side dried up instantly, and the spread between the bid and the ask widened like the Grand Canyon. For options that get priced at the midpoint, this can be rather painful for those that are short a large inventory of options.

On the episode of Market Measures referenced above, Tom and Tony highlight this phenomenon using the sell-off that occurred in global markets during late summer of this year.

The liquidity study conducted by tastytrade involved backtesting SPY options from August 1, 2015 through present. On each day, the study captured the bid/ask spread on SPY at-the-money (ATM) options that were closest to 45 days-to-expiration (DTE). The bid/ask spread is the difference between the price of the bid and the price of the ask for a given security.

In the aforementioned study, they found that before the selloff the average spread was $0.06 with the VIX trading about 13. On August 24th, the average spread widened to $0.82 and the VIX closed at 41.

Those findings are depicted in the chart below:

The above illustrates very starkly the impact dynamic markets can have on options spreads (or any security for that matter). As news flows and expectations start to reflect increased uncertainty, bid/ask spreads often widen to account for the heightened cost of risk. The same, but opposite, phenomenon can be observed in times of complacency, when bid/ask spreads shrink.

As the research referenced above was conducted on a very liquid ETF, one can only imagine how single stock options were priced during the most tense moments of August 2015 (and 2007-2009 for that matter).

Volatile markets frequently offer attractive trading opportunities to those with the stomach (or experience) necessary to tune out the emotional bias of fast-moving markets. However, traders need to be aware that extended periods of volatility can make option markets even more illiquid, which can have a significant impact on profitability and trade availability - especially for those looking to exit the wrong side of a position.

Please don't hesitate to follow-up with any questions or feedback at support@tastytrade.com

Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.

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